The perennially-optimistic crowd on Wall Street never lets the truth get in
the way of a good story. So whenever the stock market doesn't move their way,
they come up with a myriad of excuses to explain the fall. The members of what
my good friend Peter Grandich likes to call, "The Don't Worry Be Happy Crowd" appear
in the main stream media and try to deflect attention away from the truth.
What these cheerleaders are unwilling to admit is that the Federal Reserve's
myriad of QEs and manipulations of interest rates have been pumping air into
the stock market. Therefore, every exit attempt from its manipulations has,
and will, begin a painful (yet necessary) deflation of this bubble.
Instead, they fall over themselves to deliver some alternative explanation
for the deflation of asset bubbles after the Fed stops pumping in air. The
heavily-relied-upon excuse after the first quarter's negative GDP print and
6% drop in the stock market was the weather. Likewise, it was no surprise that
this October's vicious market selloff wasn't blamed on the Fed's imminent exit
from QE. On the contrary, the view being promulgated was that the market was
selling off due to Ebola fears.
The infectious disease that is ravaging Western Africa is nothing to joke
about, as it has caused the death of thousands of people. However, in the United
States to date, less Americans have died of Ebola than have been married Kim
Kardashian. But those who cheer the Feds every move would have us believe Ebola,
not the end of QE, was the primary cause of the market's woes. After all, the
Keynesian view of the world is that government spending and central bank money
printing are the very embodiment of all that is good, and Ebola is bad, it
kills people-so let's blame it.
And so the cheerleaders deftly weave this entertaining narrative; oil prices
are plummeting because nobody is going to fly a commercial aircraft from fear
of contracting Ebola. Americans will stop going to the mall, won't buy another
car and will not leave their house. For a fleeting moment, Ebola had purportedly
brought the U.S. economy and market to its knees.
Yet, the market bottomed on October 16th about one minute after the "hawkish" St.
Louis Federal Reserve President James Bullard, hinted central-bank bond buying
may get extended. Bullard apparently didn't get the Ebola talking points. The
S&P 500, which had tumbled that morning, managed to reverse course back
to unchanged after his statement, despite no new Ebola news. In fact, Mr. Bullard's
statement sent the S&P up nearly 5% during the ensuing four trading days.
And just like that, the markets fear of Ebola vanished--perhaps Bullard should
have been named the new Ebola Czar.
The truth is it's not snow or a third world infectious disease that is driving
this market. It is QE and the Fed's ability (for the time being) to keep interest
rates near zero.
The Fed started its bond purchase program known as QE1 in late 2008. Then,
ramped up QE in March of 2009 when the economy was on the brink of destruction
and the S&P 500 stood around 666. But the stock market didn't turn around
until QE 1 was put in full force.
Then, when the first round of QE purchases were completed in March of 2010,
the S&P fell by over 13% during the next few months. During roughly the
same time period, the 10-year note yield fell from 3.85% to 2.38%, commodity
prices tumbled around 10% and the M3 money supply dropped from a positive 2%,
to a negative 6% annual rate of change.
Similarly, once QE2 ended in June of 2011, the S&P fell by 17% within
three months. The 10-year note yield dove from 3.2%, to 1.8%, and again coincided
with a plummet in commodity prices and M3 money supply.
Now these events may have coincided with some other non-correlating events
such as; the Icelandic volcano eruption that temporarily closed European airports,
the occupy Wall Street movement and the end of Oprah's 25 year run on ABC -
but none of those events caused these deflationary forces to ensue; it was
the end of QE. In fact, for the past six years the stock market has been unhinged
from fundamentals and has traded predominantly on central banks' monetary policies.
However, the "happy crowd" is ignoring the dynamics of inflation and deflation.
The Fed's exit from QE is a deflationary event, just as massive money printing
is an inflationary event-plain and simple. Since asset prices are currently
so high into the stratosphere, it takes an overwhelming amount of QE to override
the gravitational force of deflation. When the stimulus is withdrawn, inflated
asset prices begin to deflate back to normalized levels.
Deflation is a healthy and healing process; as asset prices and debt levels
deflate from artificial levels. But, this also coincides with a temporary decrease
in GDP growth. This is the true message investors should glean from commodity,
stock and bond markets. Deflation and recession is also what the 2% Ten-year
Note is telling you.
Of course, the perpetually bullish will argue the drop in energy prices and
borrowing costs will be great news for the consumer and imminently boost the
stock market and the economy. They said the same thing when the WTI oil price
began its drop from $147 per barrel in the summer of 2008, to $33 six months
later. But don't be fooled by those who are incessantly upbeat. Deflation,
although a healthy occurrence in the long run, will not just bring down inflated
commodity prices, but will take equities and real estate down along for the
ride.
If we allow deflation to run its course, we can emerge as a much stronger
economy. But, the Federal Reserve will not sit idle as air streams out of the
asset bubbles it has worked so very hard to create. When asset prices stop
rising, our central bank will come to the rescue with another round of stimulus,
as the market cheerleaders cheer them on yet again.
